TD Bank: A Breakthrough For The First Horizon Deal

The Toronto-Dominion Bank (NYSE:TD, TSX:TD:CA) has been working for nearly a year to acquire First Horizon Corporation (FHN). The deal, valued at $13.4 billion, will add close to $1 billion annually to TD’s bottom line when it closes.

Unfortunately, closing is taking an awfully long time. TD and FHN first announced the deal back in February of 2022. It has been nearly a year now and they still don’t have all the regulatory approvals needed to close. On top of that, TD is paying $0.65 per share on an annualized basis for each day the deal doesn’t close–an amount that has been estimated at $1 million per day.

It is an unfortunate situation, but we may be nearing the light at the end of the tunnel. Just recently, BNP Paribas (OTCQX:BNPQF) announced that it had received all of the regulatory approvals needed to sell Bank of the West to the Bank of Montreal (BMO, BMO:CA). The Bank of the West deal isn’t a perfect parallel to TD’s First Horizon deal, but it is close enough that it can be seen as a good omen for TD’s eventual closing. Additionally, First Horizon’s recent earnings releases have seen positive growth, so TD is now getting more value for its investment than it initially looked like it was getting. For all of these reasons, I am bullish on TD Bank stock.

TD and BMO: Interesting Parallels

There are many interesting parallels between TD and BMO’s deals that lead me to think that the former’s regulatory success bodes well for the latter.

First things first, the two deals are for about the same dollar amount: $13.4 billion. That’s not really relevant to the regulatory approvals, but it should be mentioned as it has bearing on each bank’s value post-deal.

Second, TD and FHN are both buying regional banks. First Horizon is a regional bank in the Southeast, Bank of the West is (as the name implies) a bank in the West.

Third, both banks being acquired are primarily retail banks. If you look at Bank of the West’s website, you’ll see that it offers loans, deposits, and investment products to retail customers–the same thing that First Horizon does (the latter also does a lot of commercial lending). So, both companies are subject to the same regulatory concerns: lending fairly to underrepresented groups, overdraft fees, and the like. These issues came up in both TD and BMO’s “community meetings,” and BMO appears to have allayed the concerns. TD’s CEO Bharat Masrani said at a recent meeting that he was working on a “community benefit agreement” to help seal the deal, so the odds look pretty good that the First Horizon deal will close.

Is the First Horizon Deal Good?

Having established that TD’s First Horizon deal has good odds of closing, we need to look at the other side of the coin: whether the deal is any good or not. This is not an uncontroversial topic. When TD announced its deal to buy FHN, it was criticized for paying too much. It offered a 37% premium to the stock’s closing price on the day the deal was announced, resulting in a deal P/E ratio near 15. That is a steep price tag for a bank these days, but on the flip side, FHN’s earnings are growing.

In its most recent quarter, First Horizon grew its earnings by 6.2% year-over-year and 15.9% sequentially. With earnings going up, the implied deal P/E ratio is going down. If FHN earned what it earned last quarter for all of the next four quarters, then TD would only be paying 12.25 times earnings! That’s steeper than a typical big bank P/E ratio, but not by a whole lot.

On top of that, TD says that it can realize $660 million per year worth of synergies (e.g., cost reductions) thanks to economies of scale that will benefit FHN. If it does, then the deal P/E will come down even further. TD thinks that it can get the deal’s multiple down to 9.8–lower than Bank of America’s (BAC) current earnings multiple. So, TD will not be “overpaying,” as it was initially thought to be doing, if FHN’s growth continues and the synergies are realized.

Will things actually play out this way?

We can start by looking at the growth. This appears likely to continue. The Federal Reserve has been hiking interest rates this year, and banks collect higher interest income when rates go up. Whether net interest income goes up depends on factors like deposit interest, this theoretically should increase compared to loan interest when the yield curve inverts (it’s inverted now), but that hasn’t stopped banks’ NII from going up by high double digits. In general, banks have increased the interest on term deposits substantially, but not on regular savings accounts. So, margins should remain healthy.

Next, we have the synergies. TD has simply said that it expects $610 million worth of these, it hasn’t said much about where they will come from. An executive did mention in a call that the synergies in question were mainly cost synergies. TD Bank is bigger than First Horizon, so it can more readily demand discounts on bulk purchases (office supplies, backend tech infrastructure, etc.). So, we’d expect some synergies to materialize, though it would be premature to just take TD’s “$610 million” claim at face value.

First Horizon’s Impact on TD’s Valuation

To determine how FHN would impact TD’s valuation, we need to look at how TD is valued today.

Over the last 12 months, TD had:

• $35 billion in revenue.

• $20 billion in net interest income.

• $15 billion in EBIT.

• $12.7 billion in net income.

• $1.4 trillion in assets.

For its part, First Horizon had:

• $3 billion in revenue.

• $2.3 billion in net interest income.

• $1.14 billion in EBIT.

• $868 million in net income.

• $80 billion in assets.

Now, how much will the combined entity be worth?

The ‘assets’ part of the equation is a little complex, because we need to offset TD’s purchase price against First Horizon’s assets. However, because the deal is an all-cash one, the earnings and revenue impact is a matter of simple addition, and the post-deal figures will be:

• $38 billion in revenue.

• $13.56 billion in net income.

• $7.49 in earnings per share.

The EPS figure is calculated by simply adding FHN’s earnings to TD’s earnings and dividing by TD’s shares outstanding (1.81 billion). If TD’s stock price doesn’t change, then the post-deal P/E ratio will be 8.89. That’s a pretty low earnings multiple, which suggests that TD will be a bargain after the deal. The downside is that TD’s CET1 ratio will decline. TD’s CET1 ratio is currently 16.2%, among the highest (i.e., best) in the entire banking sector. Bharat Masrani said in the recent conference call that that will come down to about 11% after the deal closes, which is still well above regulatory requirements but no head-turning figure.

The Risk to Watch Out For

Because TD’s CET1 ratio is set to decline, investors will want to keep an eye on TD’s capital adequacy going forward. The CET1 ratio is a ratio of tier 1 capital (cash reserves and common equity) to risk weighted assets. “Equity” here refers to the bank’s own equity, not common stock in other companies that it may hold. Basically it tells you how much high quality assets a bank holds as a percentage of its risky assets. The higher the ratio the better. TD has disclosed that its CET1 ratio will decline as a result of the FHN deal. The predicted 11 CET1 ratio is well above regulatory requirements, but it’s a real step backward from where TD is now. So, TD will fundamentally become riskier as a result of the FHN deal.

The Bottom Line

The bottom line on TD’s First Horizon deal is that it should increase TD’s shareholder value. Financed entirely by cash, it will cause no dilution. Adding $861 million or more in earnings, it will boost EPS. Finally, with BMO’s Bank of the West deal set to close, the regulatory picture appears to be better than ever.

To be sure, this deal comes with some real risk. FHN is being acquired at a somewhat steeper valuation than banks usually trade at, and The Toronto-Dominion Bank’s CET1 ratio will decline because of the deal. However, First Horizon’s earnings are growing, and today’s macro picture provides hope that they will continue to grow.

On the whole, I’m comfortable holding TD Bank stock ahead of it closing the First Horizon deal. Banks have the economic wind at their banks right now, with interest rates rising and risks increasing only modestly. Just recently, JPMorgan (JPM) announced that asset prices implied a lowered risk of recession in 2023. If JPMorgan’s analysis is correct, and if the investors buying and selling assets are also correct, then The Toronto-Dominion Bank will do very well with its FHN deal.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.